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July 31, 2009
One of the advantages of managing a portfolio of international equities is that you get to catch up on your reading on the occasional long-haul flight. I recently went to Japan to visit companies held in the Mackenzie Saxon World Fund and the 12-hour flight provided ample opportunity for eating, sleeping and reading.
If you are a value investor, there aren't a lot of breakthrough concepts since the days of Graham & Dodd, so I decided to re-read a paperback which I have owned since 1985: How to beat the market with high-performance generic stocks by Avner Arbel. The title may sound promotional, but the author was, at the time, a professor at Cornell University, so there is plenty of academic rigour behind the thesis set out in the book. Many of the points he makes overlap with my own observations of the small cap universe, which explains why I still find the arguments refreshing 25 years later.
Simply stated, Professor Arbel's thesis is that generic, or neglected stocks outperform their better known and better-regarded comparators by a wide margin. Sticking with the relatively big cap names in the S&P500 Composite, he found that those stocks with one or zero analyst coverage returned 16.4% per year for the period 1970-1979 compared to 9.4% for those stocks with two or more analysts providing research. If tracking down analyst coverage as a proxy for neglect proves to be a problem, he suggests that low institutional ownership is an acceptable alternative as the two are highly correlated. After all, analysts get paid through commissions and there is little point in writing a research report on a company with no institutional following.
Even if you aren't a big believer in efficient markets, you should be wary of any historical formula which claims to guarantee success in the future, and the generic stock thesis seems to fall into this category. By definition, a surefire method of beating the market will self-destruct as soon as it is made public because other investors will move to take advantage of the same anomaly. I see some evidence of this with the January effect which claimed that a large part of the annual outperformance of small cap stocks actually occurred during the month of January when year end tax loss selling abated. This phenomenon was widely reported, so investors in small cap stocks began to position themselves in late December, mid-December, etc. etc. If there is still a January effect, it probably now occurs in late November.
With respect to the neglected stock incremental return, however, Professor Arbel argues that it will always be with us, even if the markets are efficient. His point is that neglected stocks suffer from an information deficiency, i.e. no research reports or media commentary. So they are perceived, at that time, to be more risky. Efficient market supporters can correctly argue that there is a 50:50 chance that this missing information could be positive or negative, but the mere fact that the entire sector is short on information means that the entire sector is underpriced by investors who crave the comfort of analyst consensus earnings.
As a result, Professor Arbel's research shows that not only do neglected stocks outperform their more popular colleagues, but they also do so on a risk-adjusted basis. This does seem to contradict the market efficiency thesis, since incremental return should only be a compensation for incremental risk, but Professor Arbel has an answer for this. Information deficiency and estimation risk are endemic to be neglected stock sector, so investors in these stocks either have to do their own homework and/or be comfortable owning a collection of stocks that are not household names. This extra research effort and emotional stability is not captured by traditional risk measures such as volatility, so at first it looks as if the neglected stock investor is setting a free ride. In reality, there is no free lunch in the stock market, but if you are willing to do your own homework, (or invest in a fund which does it for you), and you are relaxed about owning generic, no-name stocks, then Professor Arbel makes a compelling case.
As a final note, he does point out that the apparent superior returns from investing in small cap stocks and low P/E stocks is no more than a reflection of the fact that these two variables are also highly-correlated with research neglect. In fact, he argues that you would be better off investing in a neglected large cap stock than a popular small cap. His point is well-taken. As a practical matter, though, it is usually easier for investors to screen for market cap rather than investment research neglect. So, the simplest solution may be to focus on small cap stocks first and then eliminate those which are already market favourites. If that sounds familiar, it should be no surprise since it has been our approach at Saxon Funds for almost twenty five years. No wonder I enjoyed re-visiting Professor Arbel and his quirky paperback!